Wednesday, 30 April 2014

Animal Spirits – Caging our Wild Side

Money can bring out
the worst in people so it might be time to rein in the finance sector which
offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the
feeling is likely mutual). According to economic
theory, we are thought to act in a rational manner, assessing how best to spend
our cash like calculators with legs. Not
only is this an overly simplistic view but it has resulted in economists
ignoring how our emotional sides affect the economy. The global financial crisis is an example of
what can happen when animal instincts such as greed and fear take over. Economists need to take a closer look at how
our emotions can drive the economy and how we can be saved from ourselves.

Reality is messy

Economics is the study of allocating scarce resources. It focuses on how consumers make the most
from what they have. At the same time,
competition between firms ensures that products are priced efficiently so that as
much output as possible can be generated from limited input. Economists would like to think that our sober
side helps keep everything running as it should. But when money (and everything that money
brings with it) is involved, our primal nature can take over with ugly
consequences.

The worst of our traits kick in over booms and busts. When times are good, we hear stories of
people making easy money and we want in too.
Like greedy kids in a candy store, we buy a second or get shares in the latest
stock market fad in the belief that prices are sure to rise further. Prices will climb as the lust for more wealth
attracts more and more victims. But with
gains in asset prices typically outpacing the rest of the economy, this can
only last for so long.

When asset prices start heading downwards, fear is the
overriding response. Companies slash
plans for investment and lay off staff in order to stay in business. Consumers also retrench by cutting back on
spending and asset prices slide downwards as higher prices no longer seem
sensible. Assets often end up being sold
off at bargain prices as cash is needed to pay off debt taken on during better
times. Fear also reached chronic levels
among banks who would not even lend to each other in the aftermath of the
global financial crisis.

How we get ourselves
in trouble

Change is a necessary part of an economy developing over
time as certain sectors expand while others wither away. But what Keynes labelled our “animal spirits”
result in periodic bouts of instability that can hamper the expansion of any
economy over time. Rather than dealing
with our insecurities, most economists choose to ignore them. A common argument used by economists is that
financial markets constantly adjust to new information and reflect the true
value of any assets. Yet, sharp drops in
stocks or house prices cannot be reasonably explained away with this line of
thought.

The devastating effects of our emotions getting the best of
us are evident in the wake of the global financial crisis. Instead of ignoring base instincts,
economists should be thinking of ways to rein them in. One of the key ways for greed and fear to
influence the economy is through the finance sector. Banks are geared to generate as much borrowing as possible but
their loans more often than not go toward speculative investments in property
or stocks. Such lending creates
unnecessary instability with the economy as a whole suffering as boom turns to
bust.

It is no coincidence that the worst recession of a
generation comes at a time when the finance sector has grown to dominate many
developed economies. Limiting the scope
of banks, with more rules following decades of deregulation, would be a good
place to start improving the system. Measures
such as taxes on financial transactions would also take out some of the volatility
from markets for stocks and bonds by pushing investors to take a more long term
view. Such policies may lead to higher fees
for loans and lower returns from investing but the costs of continuing with the
status quo will only mount up. Better to
save us from ourselves than to let our passions run wild and cause even more
havoc.